Morgan Stanley may take all of Citi’s Smith Barney

Matthias Rieker

BrettPhilbin

NEW YORK (MarketWatch) — Why buy a part of a brokerage when you can buy the whole thing? For Citigroup Inc. and Morgan Stanley, striking a deal for all of Citi’s stake in their Morgan Stanley Smith Barney joint venture might well be too attractive to ignore.

The ball is in Morgan Stanley’s
MS, -1.71%
court. The investment bank has an option, beginning in May, to buy 14% of the brokerage from Citi
C, -0.23%
this summer, adding to its 51% stake. It could, however, go even further and offer to buy Citi’s entire 49%.

For Citi, “selling the whole stake rather than 1/3 of it would make sense” to free up capital now, said Sanford C. Bernstein & Co. analyst John McDonald.

For Morgan Stanley, “to acquire a high quality earnings business at historically low interest rates sounds like a pretty good deal to me,” said David Trone, an analyst at JMP Securities.

Morgan Stanley has pinned a big part of its future strategy on retail brokerage to diversify revenue and stabilize volatile revenue from advisory, underwriting and trading securities.

The company is already prepared, from a capital perspective, to own Morgan Stanley Smith Barney outright. In the fourth quarter, it deducted the goodwill of Citi’s stake in Morgan Stanley Smith Barney from its tier 1 capital--a key measure of a bank’s financial health--slicing off $4.2 billion. That move means Morgan Stanley wouldn’t have to take a capital hit if it were to buy the entire stake.

Citi, on the other hand, has made it clear that it would rather not retain a stake in Morgan Stanley Smith Barney because it wants to focus on commercial and retail banking. And new international capital standards would make a larger transaction more appealing. Under those so-called Basel III capital rules, the bank has tied $10 billion in capital to the joint venture that would become Tier 1 common capital if it sells its stake. (Basel III capital rules discourage so called “cross holdings,” that is ownership stakes of banks in other companies.)

Beefing up capital would please the U.S. Federal Reserve, which based its stress tests on different capital rules but evaluated banks, in part, by how they accumulated capital to comply with Basel III rules. Citi didn’t do well in the test.

The original joint-venture agreement was struck in early 2009 when Citi fundamentally restructured its strategy and decided to focus on commercial and investment banking, and retail brokerage didn’t fit with its plans. Citi set out a four-step divestiture process to Morgan Stanley: 51% initially, and an option to buy 14% in 2012, 15% in 2013, and 20% in 2014.

The transaction is so important to Morgan Stanley that it included the potential cash acquisition of a 14% stake in Morgan Stanley Smith Barney in its 2012 capital plan, to which the Fed offered no objection. In its statement on its stress test results, Morgan Stanley mentioned the potential brokerage transaction and not a possible dividend increase or share buyback.

Still, the banks would have to agree on a price, which analysts said could be a dicey process. “Yes, it makes more sense to sell 49% from Citi’s stand point, but... given the broad difference of opinion between Citi and Morgan Stanley over the value of MSSB, I don’t see the two agreeing to trade the 49% in one deal in the intermediate term,” said Matthew Burnell, Wells Fargo Securities’ analyst.

Analysts and investment bankers have already speculated that the way both banks accounted for their respective stakes suggest they disagree on how much the joint-venture is worth.

Earnings for Morgan Stanley Smith Barney are depressed because capital markets have been turbulent and the integration of the two legacy parts have been rocky, but Citi would likely demand that value is based on estimated future earnings rather than current results. Citi has walked away from deals before and has repeatedly said it won’t sell assets at fire sale prices.

Still, investment bankers have been more confident that the two will eventually agree. “They are big boys,” said one person familiar with the matter.

The joint-venture contract stipulates that both firms independently value Morgan Stanley Smith Barney when Morgan Stanley exercises its option to buy the next tranche. If the estimates are reasonably close, the value is the average of both figures. If they are far apart, an independent third estimate will be required.

But if Morgan Stanley decides to forego its option and makes a bit for the 49%, it would be a new negotiation process, similar to any other acquisition. The company would likely have to finance part of the deal through issuing potentially $10 billion in bonds, Trone said. In the current debt market and given Morgan Stanley’s strong capital, that may not be much of an issue.

Trone added, “If Morgan Stanley and Citi can agree on price, there’s a good chance they will do a deal and there’s also a chance they will go for the whole 49%.”

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